Home OP-ED It’s a Toxic Circus

It’s a Toxic Circus

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It’s a Barnum and Bailey world.

[img]489|left|||no_popup[/img] Since the clock struck midnight on the dawn of the 21st century, our greatest export has been our toxic debt.  Nothing we manufactured or assembled came close.

From 2001 through the collapse of Bear Stearns and Lehman Brothers, we have exported nearly $27 trillion in toxic assets. To put that in perspective, last year the entire U.S. gross domestic product equaled approximately half, or $13.8 trillion.

The bundling of consumer loans and home mortgages into packages of securities — a process known as securitization – was more popular on the global scene than Coca- Cola, MacDonald’s and even the Terminator movie franchise. Sorry, Arnold.

When overseas banks saw the type of profits being made by their U.S. counterparts, they wanted a piece of the action. Like other emblems of made-in-America ingenuity they craved, banks from London to Leipzig coveted earnings being posted by the Wall Street.

As a gesture of true international brotherhood, Wall Street was only too happy to oblige. The results were disastrous for our foreign trading partners.  At last count, foreign banks accounted for about 40 percent of the nearly $1 trillion in losses that now have been attributed to the toxic meltdown.

But Is Borrowing Cheaper?

The process of securitization is the shadow banking system that has funded most of the world's credit cards, car purchases, leveraged buyouts and, for a while, subprime mortgages. The system, which pools loans and slices up the risk of default, theoretically makes borrowing cheaper for everyone. 

On the plus side, securitization has put credit cards in the pockets of consumers from Seoul to Sao Paolo. It has enabled consumers worldwide to buy luxury cars and homes.  It also created record profits for banks and accounted for as much as one-fifth of their revenue over the past decade.

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Even the term securitization was enticing.  While providing a source of enormous and previously unavailable revenue, the word itself, made the concept sound safe – a perfect hook for otherwise stodgy institutions that were looking for a way to expand their profits.

The biggest single innovation in this uniquely American export was the use of off-the-balance-sheet accounting.  This accounting device allowed banks to originate loans, sell a portion to investors, and then transfer the remainder to a special purpose entity without the need to hold any capital in reserve.  This way they could book a profit on the fees and not have to show any liability on their books. 

To confound their regulators, the overseas banks followed their opposite numbers in America by incorporating these special purpose entities in places such as the Cayman or British Virgin Islands.

It was brilliant.

And Now for the Glitch

Banks could turn an otherwise low-return on equity business into one that virtually required no equity.  By shifting the risk to investors, the banks could generate huge fees without tying up their reserves.
There was one catch – the value of the assets didn’t stack up.  As the real estate market started to implode, the investors began to demand that the bankers stand behind the paper they had sold.  But because the banks were not holding adequate reserves, they couldn’t make good on their obligations. 

What started out as a perfect business model became a recipe for ruin. 
The fall of Lehman Brothers triggered a cascade of events that economists will be writing about for years.  The impact on some of the world’s most risk-adverse banking systems has been profound.

State-owned banks, such as li Landesbank Sachsen Girozentrale in Germany, had loaded up on asset-backed securities and derivatives manufactured and sold by Wall Street amounting to more than 27 times the bank's equity. To prevent its collapse the German government had to step in with $3.5 billion in taxpayer monies.  In Iceland, the banks had taken on so many of these toxic assets that the tiny island nation’s economy was on the verge of collapse.

The only good news in this otherwise dark episode is that U.S. banks had spread the risk.  Overseas greed has prevented the U.S. taxpayers from being on the hook for even greater liabilities than we already have been compelled to shoulder.
As the famous circus showman P.T. Barnum once said, “There’s a sucker born every minute.”

John Cohn is a senior partner in the Globe West Financial Group, based in West Los Angeles. He may be contacted at www.globewestfinancial.com